The real nitty-gritty of stock picking
If you want to try your hand at picking stocks that will beat out index funds, be prepared for a big helping of risk - and a lot of legwork.
By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- In your opinion, are index funds the best way to go for someone already in retirement who is trying to be sure he doesn't outlive his money? Or should one buy individual stocks and bonds? - Bill Watson, Columbia, South Carolina

Essentially this issue boils down to two questions: How much effort are you willing to put into your investing strategy? And how talented an investor are you?

I admit that I'm a big fan of index funds and, frankly, I think most investors are fooling themselves if they think they can outperform index funds over the long haul.

After all, most professional fund managers don't manage to do that. That's why Legg Mason Value Trust fund manager Bill Miller has gotten so much attention in recent years. He's pulled off the investing equivalent of Joe DiMaggio's 56-game hitting streak by beating the Standard & Poor's 500-stock index the last 15 calendar years. Even his amazing run may be coming to an end, however. (Full story)

But if you're willing to devote some time and energy to picking and monitoring individual securities and you really know how to evaluate company's prospects and build a diversified portfolio, then perhaps you can do just as well or better than the indexes.

Before you embark on such a venture, though, I think it's important that you start with an honest assessment of how much time and effort you're willing to put into this as well as a realistic look at your abilities. Let's think just for a moment about what creating a portfolio of individual stocks and bonds involves.

First, to avoid the risk of having one or two bad investment choices wipe out your savings, you've got to have a pretty broadly diversified portfolio. For the stock portion of your portfolio, that means assembling a group of at least 20 stocks, preferably more, that span the 10 or so major industry sectors.

Ideally, you'll also want to have both some large and small stocks as well as shares of fast-growing companies and some "value" shares, that is, stocks selling at bargain prices.

And I'm not talking about just buying shares of companies you've seen mentioned in a magazine or that some TV show pundit has ranted and raved about. I'm talking about really understanding the business, the outlook for earnings growth and at what price it constitutes a good buy.

On the bond side, you can make things easier for yourself by sticking to Treasuries, or perhaps top-rated or insured municipal bonds, but you've still got to build a portfolio that has issues of several different maturities so your portfolio isn't decimated should interest rates rise.

Okay, let's say you're ready to do the research - maybe you're one of those people who even enjoys it.

But are you good enough at it to make it worth your while? To come out ahead buying individual stocks, you must have some special insight that other investors don't have. In other words, you must believe that the stock is worth more than the price investors as a whole have set on those stocks. Otherwise, what's the point?

If you have no special knowledge, you would do just as well buying an index fund that tracks the market. Which leads to a natural question: do you have special insights? Are you privy to information other investors don't have or is your analysis superior to that of other investors, including the pros?

Unless you're sure that's the case, then I don't see the point of buying individual securities. Why bother if you don't have a decent shot at outperforming the market averages that index funds follow.

I suppose you could say that you may be able to improve your returns a bit by holding transactions down and keeping your costs low, assuming you take a largely buy-and-hold approach.

But you can easily find broad index funds these days that charge 0.20 percent or less. In some cases, you can find such funds with annual expenses as low as 0.07 percent. That's 70 bucks a year on a $100,000 portfolio. You'd have to run a really tight operation to run your portfolio for less than that.

That said, there's nothing that says this has to be an either-or decision. You could create a core portfolio made up of index funds and then set aside a small portion of assets that you might invest in individual securities.

If you were to take this approach, you could then limit yourself to areas of the market where you feel you have your best shot at outperforming the market averages. Maybe you have a particular expertise in tech or financial stocks. Fine. You could buy a few individual shares in those sectors.

Or perhaps you're up to doing a laddered portfolio of individual Treasury or muni bonds - that is, buying issues with staggered maturities so some issues are maturing every few years. (Click here for a recent column I did on laddering CDs - the same principle applies to bonds.)

But don't go crazy, especially with the stocks. The more you concentrate money in the shares of a few stocks, the more your portfolio can be rocked if something happens to those shares.

In addition to their low-cost, that's the beauty of index funds. You know you're getting broad diversification. One final note: If making your money last is your primary goal, then as important as smart investing is, I don't think it's the most important factor you should be thinking about.

More crucial than whether you invest in an index funds or a decently diversified portfolio you pick on your own is how much of your money you withdraw from your portfolio year to year. If you start yanking out too much early in retirement, you can run out of moolah a lot more quickly than you think no matter how sharp an investor you are.

That's why many retirement planning pros suggest you start with a modest withdrawal rate, say, four percent of your portfolio's value the first year of retirement and then increase that amount annually for inflation. And, if you would like a guaranteed income stream beyond what you get from Social Security, you might also consider an immediate (aka income or payout) annuity.

Managing your money in retirement is a whole separate issue that we don't have the time or space to get into here. But you might want to take a look at an earlier piece I did on how to create a retirement paycheck that can last a lifetime. Of course, you'll have a lot more time to think about how to create a lifetime income if you don't have to spend most of your time picking and monitoring individual stocks. One more reason to opt for index funds.

Ask the Expert: Dear reader, don't play George Soros What's wrong with holding cash, waiting to buy stocks at more attractive levels? Plenty.

Ask the Expert: Rollovers: 3 options rated When you switch jobs, it's the move you absolutely have to get right.

Ask Walter a question: E-mail us at asktheexpert@turner.comTop of page

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